The Direct Cash Flow Method
Cash flow is all the money that comes into contact with your business. It can include money received from customers and interest payments, as well as money paid out for employee wages, supplies, and taxes. A business’s cash flow statement shows the company’s profits and losses within a given time frame.
There are two basic accounting methods for drawing up a cash flow statement: the direct method and the indirect method. The direct method, while not mandatory, is recommended by International Accounting Standards, particularly for smaller business that don’t have a lot of fixed assets. The direct method uses only actual cash income and expenses to calculate total income and losses.
The indirect method, on the other hand, starts off with a statement of net quarterly income and adjusts for expenses and revenues by accounting for credit transactions and items that are not direct cash. The items on an indirect cash flow statement can include depreciation expenses, for example, even though such expenses do not involve actual cash changing hands.
When to Use the Direct Method
Accounting with the direct cash flow method is ideal for small businesses, partnerships, and sometimes sole proprietors. The direct method is more ideal for small businesses because the smaller the business, the less diverse your income sources and expenses usually are. You may also have fewer non-cash assets in general, making the direct method a better way of showing your business’s true cash flow amounts.
The direct method requires that the business be able to separate cash expense and income records from non-cash records. If you want to use this method you’ll need to keep separate records for your cash transactions and for your credit or value transactions. It’s easiest to do this if your business is new and doesn’t yet have an entrenched method of accounting – though with some work you can also introduce separate accounting practices to an established business model.
Calculating Cash Flow Using the Direct Method
A direct-method cash flow statement is usually grouped into categories of expenses and losses. These can include cash collections, operating expenses, purchases, and income tax. The amount for each category is calculated using a basic formula – for example, to calculate sales income, a business would start with the total sales amount, then add any monetary decrease in accounts receivable that occurred during the quarter.
The cash flow sheet generally lists sales income at the top, then lists various expense amounts, leaving a total amount for cash flow at the bottom.
Because the direct method of cash flow accounting and reporting requires more information and separate accounting records, many businesses default to using the indirect method. However, if you’re a stickler for accurate accounting and want your investors to stay fully informed, the direct method may be for you.